Working Capital Financing and Cash Flow in the Small Business

ABSTRACT Cash flow problems can force a profitable firm into bankruptcy because the firm is unable to pay its bills. Failure to correctly assess timing and control of cash flows is one of the primary causes of small business bankruptcy. The cash conversion cycle provides a useful framework for methods designed to estimate the amount of cash investment required for current asset financing. The purpose of this paper is to explain how this concept can be used to convert inventory and accounts receivable balances shown on financial statements into estimates of amounts of cash investment required for various levels of sales. INTRODUCTION Cash flow problems create what is probably the most unexpected hurdle on the road to success for the small business. Being able to sell merchandise at prices that are higher than costs does not insure survival. Perhaps one of the most dangerous misconceptions is the common belief among entrepreneurs that adequate profits will automatically result to adequate cash inflows. Profit, as identified in the income statement, is the product of an accounting system in which revenues and expenses are recorded on an accrual basis to reflect the point in time when these events occurred, and not the flows of cash associated with them. This process does not distinguish between liquid assets (those that are in the form of cash or that can be easily converted to cash) and non-liquid assets. Bills and debt obligations cannot be paid with profit. They must be paid in cash. Creditors can force a profitable business into bankruptcy if it does not pay its bills on time. Managers of large corporations began to notice the discrepancy between the two concepts to the 1970's as interest rates began to soar to double digit figures. Executives began to realize that a lack of cash, not profits, prevented their firms from surviving and growing (7). As a result, financial managers in most large corporations now investigate all the underlying factors controlling and influencing cash flows to discover ways of reducing the amount of cash required as well as to find ways to speed up the cash conversion cycle. A survey conducted by Greenwich Associates to 1988 revealed an extremely high level of cash management activity among large companies. Of the surveyed firms, 90 percent had made changes to their cash management systems in the past 12 months, 41 percent had set up programs to review bank costs, and 32 percent had increased cash management services (3). A GREATER CONCERN FOR THE SMALL FIRM While the financial rules for the small business may differ from those of corporate giants, evidence indicates cash management is even more important for the small firm (10). Executives of large corporations first became interested to this topic because of their concern over the opportunity cost of idle cash balances. However, in recent years cash flow problems have become more commonplace, and cash management focus has shifted more in the direction of developing procedures to deal with cash shortages rather than surpluses. Managers of large firms are now having to deal with the same types of cash flow problems that have always plagued small firms. Consequently, cash flow management tools have been developed by large organizations to deal with their problems, thereby creating opportunities for small business to adapt and benefit from the latest technology. Even though large and small firms share common types of liquidity problems, there is no comparison of the impact these have on the different sized firms. Corporate giants in need of additional cash have several options. A typical choice to meet short-term liquidity needs is to sell commercial paper. If a firm needs more permanent capitalization, it can sell stocks and/or bonds in national and international markets. Neither of these options is available to small firms, many of which are already undercapitalized (8). Often the only alternative for the small firm is to rely heavily on short-term sources of financing such as accounts payable, accruals, and lines of credit. …